Investment Valuation Methods

Gitman (2007) defines capital budgeting as the "process of evaluating and selecting long-term investments that are consistent with the business’s goal of maximising owner wealth”.

In this way capital budgeting is a process used to determine whether proposed investments of a firm or projects should be undertaken or not. The process of allocating budget for fixed investment opportunities is fundamental because they are generally long-term and not easily reversed once they are made. In other words, we can say that this is a strategic asset allocation process and management team needs to use capital budgeting techniques to determine which project will yield more return over a period of time.

Review of some techniques mentioned above:

• The net present value (NPV)

This method show that the firm should accept a project if the NPV is greater than zero and reject the project with negative NPV (NPV<0). 

•  Payback

One of the most popular alternatives to NPV is payback because it very easy to use. Payback is the length of time required to recover the cost of an investment. Typically, longer payback periods are not desirable for investment positions.

The payback's rule is simple: if three years is the cut-off date selected, only investment projects that have payback periods of three years or less are accepted.

•  Internal rate of return (IRR)

Internal rate of return (IRR) is the most important alternative to the NPV method. Internal rate of return is the rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

The rule is that we should accept the project if the IRR is greater than the discount rate and we should reject the project if the IRR is less than the discount rate. This means that discount rate is not needed for calculation of IRR but it is needed for application of this rule.



Source:
Ross, Stephen., Westerfield, Randolph., Jaffe, Jeffrey. “Corporate Finance”: pages 161-183